PDF Ebook The stock return predictability of the European banking sector
Many studies have documented that stock returns can be predicted by company-specific variables in a manner inconsistent with the accepted paradigms of modern finance. In this paper, we examine the predictability of the cross-section of bank stock returns in Europe using the influential work of Fama and French (1992). We examine predictability in the cross-section of bank stock returns using information contained in individual bank fundamental variables such as loan quality, leverage, off-balance sheet usage, and earnings structure (operating income and cost structure). We rely on two methodologies in our empirical analysis of the relationship between company-specific variables and stock returns: portfolio grouping and cross-sectional regression. The evidence of this paper for the European banking sector in the period July 1997 to June 2004 suggest that the documented dispersion in expected returns from sorting on deciles the bank size, the market to book value, the income structure and the loan quality is an expected phenomenon. Also, the results indicate that the book to market value and the loan quality explain the cross-section of average stock returns.
Many studies have documented that stock returns can be predicted by company-specific variables in a manner inconsistent with the accepted paradigms of modern finance – in particular, the capital asset pricing model of Sharpe (1964) and Lintner (1965). The influential work of Fama and French (1992) on the determinants of the cross-section of average stock returns has given focus to the literature. These cross-sectional asset-pricing studies typically have excluded financial institutions because of their high leverage and the high level of industry regulations due to the negative externalities arising from potential bank difficulties. However, because of the “special nature” of financial institutions and the importance of banks (most financial systems in Europe are dominated by banks, i.e. they are bank-based systems) there may exist important links between bank-specific fundamental variables and the cross-section of banking institutions’ expected stock returns. In this paper, we examine the predictability of the cross-section of bank stock returns in Europe by evaluating this special nature of banks as compared to regular industrial firms, and taking account the development of the new, more competitive, European banking landscape.
More specifically, in the past two decades, European banking markets have beensubjected to structural changes, which were caused by modifications occurred in the external environment, especially as a consequence of the increasing monetary and financial integration. The gradual liberalization of capital flows, the prospect of the European common market, the rapid pace of developments in information technology, the product/service innovation in financial markets, the internationalisation of banking activities, the phenomenon of disintermediation, and the competitive pressure from foreign rivals are undoubtedly some of the prominent structural features of the European banking sector.
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PDF Ebook The stock return predictability of the European banking sector
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